Basis Step Up versus Estate Tax
Executors of estates of those who died in 2010 will have to weigh a number of factors and determine whether the retroactive estate tax with a $5 million exclusion or the carryover basis regime should apply to the estate. The determination in some instances will be pretty obvious. If the estate is under $5 million in value, and especially if there is substantial appreciation in the assets held by the estate from when they were acquired by the decedent (simplifying the concept of adjusted basis), permitting the estate tax regime to apply will generally be the answer. However, an exception was illustrated in Chapter 2. On the other hand, if the estate is dramatically above $5 million permitting the estate tax to apply (rather than electing for the carryover basis rules to apply) would likely generate a substantial incremental tax cost. On the extremes, which will cover the vast majority of estates of those who died in 2010, the decision is easy. The gray area in between, while likely to only affect a rather small number of decedents (see “The New Estate Tax Numbers” in Chapter 1), will be rather complex.
The decedent, a single individual, died January 2, 2010, with an estate consisting of a single asset, a shopping center, with a tax basis of $4 million. Depending on the valuation assumptions concerning retail sales forecasts and overage (percentage) rents and their impact on cap rates, a range of $4.6 to $5.2 million is supportable as the fair value of the shopping center. If the final written appraised value of the shopping center was $5.2 million, the tax basis could be stepped up to the full $5.2 million since it is less than the $1.3 million permissible basis step up ($4 million adjusted tax basis plus $1.2 million of the $1.3 million of the permitted basis adjustment). There would be no tax cost in achieving this basis step up under the carryover basis system, and it will minimize future capital gains if the shopping center is ever sold. The executor, not heeding the advice of many advisers to withhold distributions pending clarification of the estate tax rules, buckled under pressure from the beneficiaries and distributed the interests in the shopping center to the decedent’s heirs on March 20, 2010, after each heir signed a receipt, release, and refunding bond expressly agreeing to pay any estate tax if the tax were reinstated. In December, the TRA reinstated the estate tax effective back to January 1, 2010. The appraised value of the shopping center that is obtained may impact the decisions of whether to elect for the estate tax or carryover basis to apply. The valuation of the shopping center at $5.2 million would result in some estate tax if the optional basis adjustment regime were not elected. Had a $4.6 million appraisal been obtained, there would have been no estate tax in any event, but the basis of the center would be stepped up only to the $4.6 million amount (regardless of which regime is selected in this example). Thus, depending on whether carry over basis or estate tax applies the personal representative could face significantly different pressures as to how to handle the shopping center. The executor facing the uncertainty of 2010 may face questions from beneficiaries no matter how accommodating or careful.
To Be or Not to Be — Estate Tax or Carryover Basis, That Is the Question
For some estates, the determination as to whether carryover basis is preferable may not be obvious. This is because the timing of the tax incurred under an estate, versus carryover basis election, may differ considerably. The estate tax would be required to be paid rather quickly if the default estate tax approach is used by the estate. In contrast, whereas even if a lower basis adjustment would result, under the carryover basis regime that the larger future capital gains tax that would be triggered because the tax basis of assets would not be fully stepped up to the fair market values at death could be deferred.
For larger estates, where the election of the carryover basis regime is an obvious answer, the daunting task of how to allocate the limited basis adjustment to various assets that may be received by different beneficiaries will require nimble and cautious planning considering a host of factors. This is far from a simple matter to address as the possibilities are endless. For example:
- What is the expected holding period for the property? If property, such as a family cottage, is intended to remain for generations in the family, it is less in need of an allocation to increase basis than are other assets that are more likely to be sold.
- Are other avenues to avoid, defer, or minimize the potential future capital gains tax available and how does their availability compare to other assets in the estate if the maximum basis adjustment has to be rationed to the various assets?
- If the estate holds raw land that is likely to be donated to the local church for an expansion project, the basis adjustment is less important as compared to other assets if a charitable remainder trust could be used.
- If the estate owns a shopping center, rather than sell it, a tax-deferred Code Section 1031 exchange is a likely possibility. Then, the allocation of basis to the shopping center may be less advantageous than an allocation to other assets.
- If highly appreciated securities could be contributed to an exchange fund to diversify without incurring capital gains, then these assets would be less in need of an allocation.
- If the decedent’s principal residence can be sold, and exclude gain under the home sale exclusion rules, then to the extent that the exclusion will avoid taxable gain, basis adjustment should not favor the residence.
- What will the capital gains tax rates be? While TRA extended them for two years at the low Bush era rates, will they be extended further in 2013, or will deficit worries result in much higher rates?
- What will the tax bracket and status of the beneficiaries receiving the property be? How will the Medicaid tax on passive investment income affect this?
The myriad of factors and competing interests of different beneficiaries will also make it difficult for advisers to evaluate and weigh the many options. How will counsel to the executor advise on the allocations? If there are no directives in the will (and few have any since no advisers really thought that the estate tax repeal scenario would occur) as to how the basis adjustment should be allocated, what framework can be used to make a determination? Executors might consider carving out specific assets that should or should not receive an allocation. This might include a direction not to favor a family business in the basis adjustment allocation because the testator’s intent is that it not be sold.
2010 Carryover Basis Rules
The general rule is that the heir’s basis will be the lower of: (a) the fair market value of the asset, or (b) the decedent’s tax basis. Tax basis, in simplified terms is what the decedent paid to buy the asset (or construct it), plus the cost of improvements and less any depreciation claimed. For stock, the adjusted tax basis is the cost of purchasing the shares adjusted for splits, or other changes.
For those dying in 2010, their estates will qualify for a limited basis step up, if the executor elects to have the carryover basis rules apply. The Bush estate tax repeal effectively created an income tax cost to replace the estate tax. If you die owning a stock for which you paid $1, and it is worth $5 million under 2009 law, you would have to pay an estate tax of approximately $675,000 ($5 million value less $3.5 million exclusion x 45 percent) but then your heirs’ “investment” or “tax basis” in that stock would be increased to the $5 million value at your death (IRC Sec. 1014). If your heirs later sold the stock for $5 million, they would not pay capital gains tax. In 2010, if the estate tax regime applies (which it will unless the executor elects otherwise), no estate tax would be due as a result of the $5 million estate tax exclusion, and the stock would have its basis stepped up to the $5 million fair value at death.
Under the new 2010 law, the basis step up is limited under an arcane set of new rules that even tax geeks had hoped they would never have to learn. For many, the TRA assures they won’t. These rules are called “carryover basis”. Every estate will get to increase the tax basis in assets owned at death by $1.3 million. The basis increase is only $60,000 for nonresident aliens. And $3 million more can be allocated to increase basis of property received from a deceased spouse. These rules will require substantial record keeping. The rules are truly arcane, even for tax laws!
These new rules are similar to what a donee of property received as a gift during the donor's lifetime, must do: determine the donor's income tax basis and then make certain adjustments. (IRC Sec. 1015). More specifically, the basis of property received as a gift is the adjusted basis of the donor, subject to a few special rules. If the donor's tax basis is greater than the fair value of the property at the date of the gift, the basis for determining a loss is limited to the fair value of the property on the date of the gift. This is to prevent the donee from recognizing a tax loss for income tax purposes on property received as a gift.
The second special rule is that if the donor giving you the property had to pay gift tax on the gift, the adjusted basis of the property is increased by the amount of gift tax paid, so long as the increase is not to an amount more than the fair value of the property.